IE22. This example illustrates the journal entries for a purchased put option on the entity’s own shares that will be settled (a) net in cash, (b) net in shares or (c) by delivering cash in exchange for shares. It also discusses the effect of settlement options (see (d) below).
Assumptions:
Contract date 1 February 2002
Exercise date 31 January 2003
(European terms, i.e. it can be exercised only at maturity) Exercise right holder Reporting entity (Entity A) Market price per share on 1 February 2002 CU100 Market price per share on 31 December 2002 CU95 Market price per share on 31 January 2003 CU95 Fixed exercise price to be received on 31 January 2003 CU98
Number of shares under option contract 1,000
Fair value of option on 1 February 2002 CU5,000 Fair value of option on 31 December 2002 CU4,000 Fair value of option on 31 January 2003 CU3,000 (a) Cash for cash (‘net cash settlement’)
IE23. On 1 February 2002, Entity A enters into a contract with Entity B that gives Entity A the right to sell, and Entity B the obligation to buy the fair value of 1,000 of Entity A’s own outstanding ordinary shares as of 31 January 2003 at a strike price of CU98,000 (i.e. CU98 per share) on 31 January 2003, if Entity A exercises that right. The contract will be
settled net in cash. If Entity A does not exercise its right, no payment will be made. Entity A records the following journal entries.
1 February 2002
The price per share when the contract is agreed on 1 February 2002 is CU100. The initial fair value of the option contract on 1 February 2002 is CU5,000, which Entity A pays to Entity B in cash on that date. On that date, the option has no intrinsic value, only time value, because the exercise price of CU98 is less than the market price per share of CU100. Therefore it would not be economic for Entity A to exercise the option. In other words, the put option is out of the money.
Dr Put option asset CU5,000
Cr Cash CU5,000
To recognise the purchased put option.
31 December 2002
On 31 December 2002 the market price per share has decreased to CU95.
The fair value of the put option has decreased to CU4,000, of which CU3,000 is intrinsic value ([CU98 – CU95] × 1,000) and CU1,000 is the remaining time value.
Dr Loss CU1,000
Cr Put option asset CU1,000
To record the decrease in the fair value of the put option.
31 January 2003
On 31 January 2003 the market price per share is still CU95. The fair value of the put option has decreased to CU3,000, which is all intrinsic value ([CU98 – CU95] × 1,000) because no time value remains.
Dr Loss CU1,000
Cr Put option asset CU1,000
To record the decrease in the fair value of the option.
On the same day, Entity A exercises the put option and the contract is settled net in cash. Entity B has an obligation to deliver CU98,000 to Entity A and Entity A has an obligation to deliver CU95,000 (CU95 × 1,000) to Entity B, so Entity B pays the net amount of CU3,000 to Entity A.
Dr Cash CU3,000
Cr Put option asset CU3,000
To record the settlement of the option contract.
(b) Shares for shares (‘net share settlement’)
IE24. Assume the same facts as in (a) except that settlement will be made net in shares instead of net in cash. Entity A’s journal entries are the same as shown in (a), except:
31 January 2003
Entity A exercises the put option and the contract is settled net in shares. In effect, Entity B has an obligation to deliver CU98,000 worth of Entity A’s shares to Entity A, and Entity A has an obligation to deliver CU95,000 worth of Entity A’s shares (CU95 × 1,000) to Entity B, so Entity B delivers the net amount of CU3,000 worth of shares to Entity A, that is, 31.6 shares
(CU3,000 ÷ CU95).
Dr Equity CU3,000
Cr Put option asset CU3,000
To record the settlement of the option contract.
(c) Cash for shares (‘gross physical settlement’)
IE25. Assume the same facts as in (a) except that settlement will be made by receiving a fixed amount of cash and delivering a fixed number of Entity A’s shares, if Entity A exercises the option. Similarly to (a) and (b) above, the exercise price per share is fixed at CU98. Accordingly, Entity B has an obligation to pay CU98,000 in cash to Entity A (CU98 × 1,000) in exchange for 1,000 of Entity A’s outstanding shares, if Entity A exercises its option. Entity A records the following journal entries.
1 February 2002
Dr Equity CU5,000
Cr Cash CU5,000
To record the cash received in exchange for the right to deliver Entity A’s own shares in one year for a fixed price. The premium paid is recognised directly in equity. Upon exercise, it results in the issue of a fixed number of shares in exchange for a fixed price.
31 December 2002
No entry is made on 31 December because no cash is paid or received and a contract to deliver a fixed number of Entity A’s own shares in exchange for a fixed amount of cash meets the definition of an equity instrument of Entity A.
31 January 2003
Entity A exercises the put option and the contract is settled gross. Entity B has an obligation to deliver CU98,000 in cash to Entity A in exchange for 1,000 shares.
Dr Cash CU98,000
Cr Equity CU98,000
To record the settlement of the option contract.
(d) Settlement options
IE26. The existence of settlement options (such as net in cash, net in shares or by an exchange of cash and shares) has the result that the put option is a financial asset. It does not meet the definition of an equity instrument because it can be settled otherwise than by Entity A issuing a fixed number of its own shares in exchange for receiving a fixed amount of cash or another financial asset. Entity A recognises a derivative asset, as illustrated in (a) and (b) above. The accounting entry to be made on settlement depends on how the contract is actually settled.